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Bitcoin Prices Blast Through $100, Driving Speculators Wild

If you're like most people, you've probably been hearing a bit about "Bitcoin" recently.

And, if you're like most people, you'll probably not know what it is or what to think about it--or what the fuss is all about.

Here's a snapshot.

Bitcoin is an electronic currency--a new form of money.

Bitcoins take the form of strings of numbers that can be electronically owned by and transferred among individuals and organizations. For now, the currency is primarily used for payments by fringe retailers or illegal transactions, but it is being accepted at more and more places. And organizations that exchange Bitcoins for standard currency are now being approved to operate as banks.

The premise and promise of Bitcoin--the part that appeals to folks who don't happen to be gold bugs or cryptography geeks--is that the current plan is for only a finite number of Bitcoins to be created. This is in direct contrast to standard government-issued currencies, which governments can always print more of. If the supply of Bitcoins remains finite, this should theoretically eliminate inflation, which is one of the biggest drawbacks of paper money.

So Bitcoin is conceptually very interesting, especially since it is not issued by a government agency.

What has suddenly grabbed the public's attention about Bitcoin, however, is the recent explosion in the value of the currency.

Because the number of Bitcoins is limited, their value increases rapidly when more people want them. And when the value of something increases rapidly, more people want it because they see it as a means of making money. So the initial price increases fuel future price increases which fuel more future price increases...at least for a while.

This dynamic has fueled the inflation of every asset bubble in history. And they have all ended badly. So it behooves people to analyze the sustainability of such price increases carefully.

When Bitcoin was launched in 2010, the currency initially had very little value. Quickly, however, the price of each "coin" soared above $25, making the initial Bitcoin believers rich. Then prices collapsed, with coins trading down to $5 again, making Bitcoin adherents into fools. Then Bitcoin prices began a slow and steady rise that has suddenly gone parabolic.

At the beginning of last month Bitcoins could be exchanged for about $35.

Now they're changing hands at above $90.

This explosive price increase has many intelligent people crying "bubble!"

And these intelligent people may well be right.

But if there's one lesson that gets repeated again and again in bubbles, it's that prices can rise much higher and bubbles can last much longer than most observers think.

Internet stocks, for example, were first described as a "bubble" in 1995, a full five years before the peak. And the amount of money made in those next five years made everyone who was skeptical early on look and feel like a fool. House prices, meanwhile, were described as a "bubble" as early as 2002 and 2003. And it wasn't until 2007, many years later, that house prices finally peaked.

Driving prices in all bubbles, of course, is the possibility that the price action might not actually be a bubble.

That applies to Bitcoin, too.

If Bitcoins become an accepted currency everywhere in the world, if governments don't make Bitcoin transactions illegal, and if the supply of Bitcoins remains finite (if the systems aren't hacked or the anonymous creators don't get greedy and decide to create many more), then Bitcoin prices could go much, much higher.

After all, how much would you pay for a currency that could be used everywhere in the world and would never demolish your savings by losing value to inflation?

You might pay a lot.

And, as with any asset, it would be hard if not impossible to determine how much was "too much"--because determining the value of any asset or means of exchange is always a subjective exercise.

At the same time, though, there are many big risks that could bring the Bitcoin frenzy to a quick and brutal end.

Governments, for example, might decide that Bitcoin undermines the value of their own legal currencies--and ban it. In the U.S., for example, only Congress has the power to print money, and Congress might well decide that Bitcoin is money (which, it is).

Or, Bitcoin's technology could be hacked, allowing Bitcoins to be stolen from their owners.

Or someone could make counterfeit Bitcoins.

Or the anonymous creators of Bitcoin, who reportedly still own lots of Bitcoins, could decide to create a lot more Bitcoins, thus debasing the value of each unit of the currency.

Or Bitcoin could never really gain mass-market acceptance.

In short, there are lots of reasons why Bitcoin might not be the wonderful "store of value" that Bitcoin fanatics and investors say it is--and, instead, might just become the next tulip bulb or dotcom stock bubble.

On the other hand...

Bitcoin might fulfill its promise.

And/or Bitcoin might make some speculators fantastic amounts of money in the hours, days, months, or years before its value crashes.

So you can understand why not just monetary theorists and technology folks and speculators are excited about Bitcoin.

(Pssst... in the time it took to write this article, the value of a Bitcoin just soared above $100 for the first time.)